Retained Premium

What Is Retained Premium?

Retained premium, in the context of insurance, primarily refers to the portion of gross written premium that an insurer keeps for its own account after accounting for reinsurance arrangements. This concept is fundamental to insurance accounting, as it represents the direct financial exposure and potential profitability an insurer assumes from its policyholder base. While an insurer may collect a full premium from a client, it often cedes a portion of the associated risk, and thus a portion of the premium, to a reinsurer. The remaining amount is the retained premium, which funds the insurer's reserves and covers potential future claim payouts.

History and Origin

The concept of retained premium has evolved alongside the development of the modern insurance industry, particularly with the advent and expansion of reinsurance. Early forms of risk-sharing existed for centuries, but formal reinsurance treaties became more common in the 19th century as insurers sought to manage increasingly large and complex risks. The necessity of clearly accounting for the portion of risk, and therefore premium, that an insurer kept versus what it passed on, became paramount for financial solvency and regulatory oversight. Modern accounting standards, such as those set by the National Association of Insurance Commissioners (NAIC) in the United States, provide frameworks for how insurance companies report their financial position, including the classification of premiums.¹⁸, ¹⁹, ²⁰ For instance, the NAIC's Statutory Accounting Principles (SAP) are designed to ensure consistent reporting among insurers and assist state insurance departments in monitoring solvency.¹⁷ Globally, standards like IFRS 17 have further refined how insurers recognize revenue from contracts, impacting how premiums, earned and unearned, are measured and disclosed.¹³, ¹⁴, ¹⁵, ¹⁶

Key Takeaways

• Retained premium is the portion of gross premium that an insurer keeps after ceding some risk to reinsurers.
• It represents the net premium an insurer assumes and is crucial for assessing its direct risk exposure.
• Retained premium contributes to an insurer's financial stability, enabling it to meet future claims.
• Regulatory bodies emphasize proper accounting of retained premiums to ensure insurer solvency.
• The concept is distinct from "unearned premium," though both relate to premiums held by the insurer.

Formula and Calculation

The calculation of retained premium is straightforward, reflecting the amount of premium that an insurer does not pass on to a reinsurer. It is also often referred to as "net written premium" or "net premium earned" when considering the portion of the premium for which the insurer is directly responsible.

The basic formula is:

Where:

• Gross Written Premium (GWP): The total amount of premium from all policies written by the insurer during a specific period before any deductions for reinsurance or cancellations.
• Ceded Premium: The portion of the gross premium that the primary insurer pays to a reinsurance company in exchange for the reinsurer assuming a share of the risk.

This formula highlights the insurer's actual premium revenue that it retains for its own operations and risk-bearing capacity.

Interpreting the Retained Premium

Interpreting retained premium involves understanding an insurer's appetite for risk management and its financial strategy. A higher retained premium ratio (retained premium as a percentage of gross written premium) indicates that an insurer is keeping more of the risk for its own balance sheet and potentially aims for higher profitability from its underwriting activities. Conversely, a lower retained premium ratio suggests a greater reliance on reinsurance to offload risk, which can reduce volatility but also limit upside potential.

Analysts and regulators examine retained premium figures to gauge an insurer's capital adequacy and its ability to absorb potential losses from the risks it has assumed directly. It provides insight into the actual revenue recognition and the underlying exposure of the insurer's core operations before the impact of reinsurance recovery.

Hypothetical Example

Consider "SecureShield Insurance," which writes a new insurance policy with a total annual premium of $1,000,000 for a large commercial property. SecureShield assesses the risk and decides it is too concentrated to hold entirely on its books.

1. Gross Written Premium: SecureShield collects $1,000,000 as the gross written premium for this policy.
2. Reinsurance Arrangement: SecureShield enters into a reinsurance agreement to cede 40% of the risk and premium associated with this policy to "GlobalRe," a reinsurance company.
3. Ceded Premium Calculation: $$\text{Ceded Premium} = \$1,000,000 \times 40\% = \$400,000$$
4. Retained Premium Calculation: $$\text{Retained Premium} = \text{Gross Written Premium} - \text{Ceded Premium}$$ $$\text{Retained Premium} = \$1,000,000 - \$400,000 = \$600,000$$

In this scenario, SecureShield Insurance has a retained premium of $600,000 for this specific policy. This means SecureShield is directly responsible for covering potential claims up to its share of the risk corresponding to this $600,000, while GlobalRe is responsible for the remainder.

Practical Applications

Retained premium figures are critical in various aspects of the insurance industry:

• Financial Reporting and Analysis: Insurers report retained premium on their income statement as net written premium, which directly impacts their reported underwriting results. Financial analysts use this to evaluate an insurer's core profitability and the effectiveness of its underwriting strategies.
• Regulatory Oversight: Regulatory bodies, such as state insurance departments in the U.S. and organizations like the NAIC, closely monitor retained premiums to ensure that insurers maintain adequate capital and reserves to support the risks they hold. This is essential for policyholder protection. The global reinsurance market, which influences how much premium is retained, is also subject to ongoing analysis and regulation.⁹, ¹⁰, ¹¹, ¹²
• Risk Management Strategy: An insurer's decision on how much premium to retain versus cede reflects its overall risk appetite and capacity. Companies with strong financial positions and sophisticated actuary models might opt to retain more premium, while those facing higher or more volatile risks might cede a larger portion.
• Capital Allocation: The amount of retained premium directly correlates with the capital an insurer needs to hold. Higher retained premiums typically necessitate greater capital reserves to comply with solvency requirements.

Limitations and Criticisms

While a vital metric, retained premium has its limitations. It provides a snapshot of an insurer's current risk assumption but doesn't fully encapsulate the dynamic nature of risk management or the full financial health of a company.

One criticism is that a high retained premium, while signaling a strong risk appetite, could also expose an insurer to significant losses if its underwriting is flawed or if unexpected catastrophic events occur. Conversely, excessive reliance on reinsurance (leading to low retained premium) can reduce an insurer's net profitability and its direct relationship with the underlying insured risks. The complexities of international accounting standards, such as IFRS 17, also highlight the challenges in consistently measuring and reporting premium income across jurisdictions, which can impact the comparability of retained premium figures.⁵, ⁶, ⁷, ⁸ Moreover, the concept of "retained" can sometimes be confused with "unearned" premium, which is a liability.

Retained Premium vs. Unearned Premium

"Retained premium" and "unearned premium" are both crucial concepts in insurance accounting, but they refer to different aspects of an insurer's financial position.

Retained premium refers to the portion of the gross written premium that an insurer keeps after paying a share to reinsurers. It is a measure of the net premium the insurer has decided to underwrite directly, and it reflects the amount of premium income (whether earned or unearned) that remains on its books after reinsurance arrangements. It's a key indicator of an insurer's net risk exposure from its policies.

Unearned premium, on the other hand, is a liability on an insurer's balance sheet. It represents the portion of premiums collected in advance for which the insurance coverage has not yet been provided. As time passes and coverage is provided, the unearned premium is gradually "earned" and recognized as revenue on the income statement. If a policy is canceled mid-term, the unearned portion of the premium (minus any cancellation fees) may be refunded to the policyholder.¹, ², ³, ⁴

The confusion often arises because the "unearned" portion of a premium is indeed "retained" by the insurer until it's earned. However, "retained premium" typically refers to the net premium held by the primary insurer after reinsurance, regardless of whether that premium has been earned yet.

FAQs

Q1: Why do insurance companies cede premiums, reducing their retained premium?

A1: Insurance companies cede, or transfer, premiums to reinsurance companies to reduce their exposure to large or concentrated risks. This helps them manage their capital, limit potential losses from catastrophic events, and increase their overall underwriting capacity for new policies.

Q2: How does retained premium affect an insurer's profitability?

A2: Retained premium directly impacts an insurer's profitability. The insurer earns its profit from the retained portion of the premium after paying claims and operating expenses related to the risks it keeps. A higher retained premium can lead to greater profits if the insurer's underwriting is successful and claims are low, but also exposes it to higher losses if claims are severe.

Q3: Is retained premium the same as gross written premium?

A3: No. Gross written premium is the total premium collected before any amounts are ceded to reinsurance companies. Retained premium is the portion of that gross premium that the insurer keeps for itself after the reinsurance transactions have occurred.

Q4: How do regulators use retained premium figures?

A4: Regulators, such as the NAIC, use retained premium figures to assess an insurer's financial solvency and ensure it maintains sufficient reserves to cover its direct liabilities to policyholders. It helps them monitor whether an insurer is taking on an appropriate amount of risk relative to its capital.

Q5: Can retained premium be negative?

A5: While retained premium is typically a positive figure, in unusual circumstances, if an insurer cedes more premium than it writes, or if significant cancellations or adjustments occur, it could theoretically result in a negative net written premium, which would include the retained component. However, this is rare for ongoing operations and would typically indicate significant financial issues.